Four Things You Need to Know About Payday Loans

A new day is dawning for “payday” loans.

The Consumer Financial Protection Bureau recently proposed a set of rules that would offer more protections to borrowers who take out payday loans – high-interest, short-term loans, often targeted to lower-income borrowers.

The proposed rules would require that lenders assess whether borrowers can afford to pay back their loans, among other things. The proposed protections would apply to payday loans as well as to other types of costly loans, such as auto title loans and deposit advance products.

The CFPB has begun collecting public comments and will continue to do so until Nov. 7. The proposed rules, which do not require Congressional or other approvals, are expected to go into effect next year.

In the meantime, here are four things you need to know about payday loans.

What Are Payday Loans?

Payday loans are loans for small amounts of money – often $500 or less – that are generally due on the borrower’s next payday. Consumers often turn to payday loans when they’re strapped for cash, hit a road bump or can’t wait until their next paycheck to pay their bills.

The loans are paid back in a number of ways. Borrowers might be required to give the lender access to their bank account. Alternatively, you might have to write a post-dated check for the amount you’ve borrowed, plus a finance fee. The lender has the option to deposit the check when the loan is due, which is generally within 14 days.

Keep in mind, payday loans are very costly, particularly compared to other types of loans. Fees can range from $10 to $30 for every $100 borrowed. That means a two-week payday loan with a $15 per $100 fee would equate to an annual percentage rate of charge, or APR, of 400 percent. Credit cards, in contrast, typically have an APR ranging from 12 to 30 percent.

What Are The Dangers?

Most people simply can’t pay back the loans when they’re due. As a result, they end up rolling them over, or taking out new ones – falling into what the CFPB calls a “debt trap.” The more loans a borrower takes out, the more fees and interest he pays.

Let’s say you took out a $100 loan with a $15 finance charge. If you rolled it over three times, you’d end up paying $60 to borrow $100.

Nearly 70 percent of payday loan borrowers take out a second payday loan, and one in five end up taking out at least ten or more loans, one after another, the CFPB found.

“Too many borrowers seeking a short-term cash fix are saddled with loans they cannot afford and sink into long-term debt,” CFPB Director Richard Cordray said when the proposed rules were announced in June. “It’s much like getting into a taxi just to ride across town and finding yourself stuck in a ruinously expensive cross-country journey.”

The payday loan debt trap can have a ripple effect. When people face unaffordable payday loans, they might not be able to meet their other obligations, like basic living expenses or medical bills.

“Payday loans can dramatically increase your likelihood of being late on bills, or possibly going bankrupt,” said Pamela Banks, senior policy counsel at Consumers Union, which supports the CFPB’s proposed rules.

What Would The New Rules Do?

The new rules offer a number of protections. Lenders generally would be required to assess whether a borrower can afford the full of amount of each payment when its due – and still be able to pay his or her other bills.

The proposal also would limit the number of payday loans a borrower can take out in quick succession.

In addition, payday lenders would have to alert borrowers before trying to debit their accounts to collect payments. After two straight unsuccessful attempts, the lender would be prohibited from debiting the account again unless the lender obtained a new and specific authorization from the borrower.

Why is that important? When lenders try unsuccessfully to withdraw payments from borrowers’ accounts, insufficient fund fees from the borrower’s bank or credit union can quickly pile up.

What Should You Do If You’re Thinking About Taking Out A Payday Loan?

The proposed rules go a long way toward offering protections for consumers.

But payday loans remain an expensive proposition. The burden is still on borrowers to tread carefully and act responsibly.

Before you take out a payday loan, you should consider alternatives such as a short- term loan from a credit union or a bank, or a cash advance on your credit card. These alternatives also carry fees, but they are typically far less than those carried by payday loans. If you're military, contact your service's relief society. They can offer no cost, no interest loans, or even grants, to service or family members to help see them through a financial challenge.

Most important: Create a budget and stick to it. Do the best you can to live within your means. Establish an emergency fund of three to six months of living expenses that you can tap in the event you face an unforeseen hardship.

At the end of the day, your best protection from payday loans is avoiding them in the first place.